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Risk Manageemnt without markets

The real test of risk management is provided by the financial Darwinism of the markets. By reading market signals about products--pricing of assets, pricing of insurance on those prices--banks develop models that can inform them about risk. By reading market signals about their own financial health--their cost of capital, their borrowing cost, the cost to insure their debt, the willingness of customers to enter into trades--risk managers get a view about the risks of their own portfolios and the strength of the business model.

-- John Carney.

The "No FMore Lehmans" rally, however, scrambles these signals. Shareholders, bondholders, counterparties can become indifferent to risk. Business models can seem more effective than they actually are. In this situation, financial executives cannot appeal to the external market to determine whether they have the right business models, asset portfolios or capital structures. They just have to guessitimate.

Students of the history of economics may recognize the similarities between this situation and the old 'socialist calculation debate.' That debate centered on the question of whether central planners were able to correctly figure out how much of something should be manufactured in an economy without price signals. Most everyone today agrees that pricing is absolutely central to the ability to make calculations about how to expend limited resources.

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